Derivatives and Mutual Funds – What Do You Think?

Last week, the SEC voted
unanimously to seek public comment on what it termed “a wide range of
issues raised by the use of derivatives by mutual funds and other
investment companies regulated under the Investment Company Act.”

The SEC is seeking that input through a
concept release, which is a Commission-approved document that poses an
idea or ideas to the public to get their views. According to the
announcement, the SEC will use the comments received in response to this
concept release to “help determine whether regulatory initiatives or
guidance is needed that would continue to protect investors and fulfill
the purposes underlying the Investment Company Act.”

“The derivatives markets have undergone
significant changes in recent years, and the Commission is taking this
opportunity to seek public comment and ensure that our regulatory
approach and interpretations under the Investment Company Act remain
current, relevant, and consistent with investor protection,” said SEC
Chairman Mary L. Schapiro.

The SEC notes that when the
Investment Company Act was enacted in 1940, it did not contemplate funds
investing in derivatives as they may do today. “Indeed, the use and
complexity of derivatives have grown significantly over the past two
decades,” it acknowledged in a fact sheet.

(Cont...)

The Concept Release asks
for information on how different types of funds use various types of
derivatives as well as the benefits, risks and costs of using
derivatives, among other things. Additionally, it asks for comment on
several specific issues under the Investment Company Act implicated by
funds’ use of derivatives.The SEC fact sheet identified those issues as:

Restrictions on Leverage
– The Investment Company Act restricts the manner in which, and the
extent to which, funds may incur indebtedness and may leverage their
portfolios. The Concept Release discusses the treatment of derivatives
under these restrictions. The Concept Release asks, among other things,
how to measure the amount of leverage that a fund incurs when it invests
in a derivative.

Fund Portfolio Diversification
– The Investment Company Act does not require the portfolios of funds
to be diversified, but does require them to disclose in their
registration statements whether they are diversified or not. The Act
also prohibits a fund from changing its classification from diversified
to non-diversified without shareholder approval. The Concept Release
asks, among other things, how a fund should value a derivative to
determine the percentage of the fund's assets that's invested in a
particular company for diversification purposes.

Fund Investments in Certain Securities-Related Issuers
– The Investment Company Act generally prohibits funds from acquiring
any security issued by, or any other interest in, the business of a
broker, dealer, underwriter or investment adviser. However, funds that
meet certain conditions may acquire some securities issued by companies
engaged in such business. The Concept Release asks, among other things,
how investing in a derivative issued by a broker-dealer may be different
from, or similar to, investing in the broker-dealer's stock or bond.

Fund Portfolio Concentration
– The Investment Company Act does not prohibit funds from concentrating
their investments in a particular industry, but does require funds to
disclose their industry concentration policies in their registration
statements. It also prohibits funds from deviating from those policies
without shareholder approval. The Concept Release asks, among other
things, how funds determine the industry or industries to which they may
be exposed through a derivative investment.

Valuation of Fund Assets
– The Investment Company Act specifies how funds must determine the
value of their assets. The Concept Release asks, among other things,
whether the Commission should issue guidance on how funds should value
derivatives in their portfolios.

The
Concept Release will be published in the Federal Register and
commenters will have 60 days from the date of publication to submit
their comments.